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The marijuana industry is growing by leaps and bounds, and pot stock investors know it, which is why most marijuana stocks have vaulted higher by triple- or quadruple-digits over the trailing two-year period.

According to recently released data from ArcView, in partnership with BDS Analytics, the legal weed industry in North America grew by 33% in 2017, generating $9.7 billion in sales. Between 2018 and 2021, sales growth is projected to rise at an average annual pace of 28%, pushing sales to almost $25 billion by the end of 2021. For added context, that's about $3 billion higher than what ArcView had been forecasting for 2021 in its previous years' report. That's how quickly the industry is growing.

It also hasn't hurt that consumers have dramatically changed how they view pot, at least in the United States. In each and every national poll, a clear majority of respondents (often between 59% and 64%) favors the idea of legalizing marijuana, with support for medicinal cannabis usually much higher.

Image source: Getty Images.

Canada leads the way

However, it's not the U.S. markets that are the breeding ground of success for investors. The Schedule I classification of cannabis at the federal level ensures that marijuana businesses face numerous obstacles, making investing in U.S. weed stocks an often unwise decision.

Instead, it's Canada that's been the blueprint for marijuana success. Canada legalized medicinal cannabis back in 2001, with Health Canada overseeing the implementation of that law and the approval of growing licenses ever since. More recently, Canada's federal government is reviewing legislation that would legalize recreational pot by this coming summer. With a tax agreement already in place with nearly every province, and conservatives representing a minority in parliament, Canada looks to be on track to become the first developed country in the world to legalize recreational weed.

If Canada does move forward with legalization shortly after a June 7 Senate vote, the expectation is it could generate $5 billion in added annual sales, if not more. This additional revenue is expected to make pot stocks very profitable, which is why investors have had an insatiable appetite for this budding industry as of late.

But what happens if Canadian marijuana stocks aren't as profitable as everyone expects?

Image source: Getty Images.

Uh-oh! Marijuana EPS estimates are falling

After reviewing Wall Street's 2019 earnings per share (EPS) expectations – i.e., the first full year of legalization – for some of the largest Canadian pot stocks by market cap, an interesting trend emerged. Below you'll see Wall Street's EPS estimated (in Canadian dollars (CAD)) from 30 days ago, as well as the most up-to-date estimate:

Three probable reasons pot stock EPS estimates are declining

With few exceptions, full-year EPS estimates for Canadian marijuana stocks have fallen across the board over the past month. What gives, you ask? I suspect it's a combination of three factors.

1. There's no precedent to having a developed country legalize weed

For starters, no one on Wall Street has any idea what to expect if Canada legalizes recreational pot. Demand could soar out of the gate, be incredibly lumpy, or progress fairly steadily. Because no developed country has ever legalized cannabis for adult use before, analysts have no precedent to lean on, making their estimates as fluid as ever.

Image source: Getty Images.

2. Capacity expansion could create oversupply and ransack margins

Second, oversupply is a genuine concern that has the potential to decimate pot stock margins. Just as Wall Street is unsure what demand, sales, and margins might look like out of the gate, assuming approval, growers are in somewhat the same boat. They're racing to expand their production capacity as quickly as their balance sheets will allow, and there's the growing possibility that there could be more supply than demand, even with export channels available, in the years to come.

Here's a brief look at what the aforementioned pot stocks bring to the table:

Canopy Growth Corp. already has seven facilities operating across 665,000 square feet of growing space, but is currently working on 4 million additional square feet of greenhouses in British Columbia. Though Canopy Growth hasn't offered an estimate of its production capacity, I'd suspect it's over 300,000 kilograms per year.

Aphria's management team has guided to expect around 230,000 kilograms of annual production, according to its most recent quarterly operating update. This will predominantly come from Aphria's flagship four-phase project, which is expected to generate 100,000 kilograms of cannabis a year, and 120,000 kilograms from a partnership with Double Diamond

MedReleaf, which went public last year, anticipates 140,000 kilograms of production per year. This includes 35,000 kilograms from its Markham and Bradford facilities combined, as well as the 105,000 kilograms from the Exeter Facility. Just under two weeks ago, MedReleaf acquired 164 acres of property – 69 of which contains a greenhouse (known as Exeter) that it plans to retrofit to grow

OrganiGram Holdings aims to organically expand at its Moncton location in New Brunswick. Sticking with one location should help keep its costs down, as well as give OrganiGram an opportunity, across its four-phase project, to boost its annual production to 113,000 kilograms of

Finally, The Supreme Cannabis Company is working with 342,000 square feet with its 7ACRES facility. Though there is no single production estimate from the company, I'd imagine that if OrganiGram can yield 65,000 kilogram from 429,000 square feet, Supreme Cannabis Company should be near 50,000 kilograms a year.

Just these five growers could generate close to 800,000 kilograms a year. Yet there are dozens of additional licensed growers I've not mentioned here. With demand estimated to be around 800,000 kilograms a year, oversupply and margin erosion is a real possibility.

Image source: Getty Images.

3. Dilution is beginning to seriously weigh on EPS

Finally, it's quite possible that the impact of dilution is surprising even Wall Street analysts. You see, marijuana companies really aren't generating much in the way of positive cash flow. Even those that are profitable are bringing in only a few million dollars in cash flow. That's not nearly enough to fund $100 million capacity expansion projects. In order to boost capacity, Canadian pot stocks have turned to bought-deal offerings.

A bought-deal offering is a fancy way of saying that a publicly traded company is selling common stock, debentures, warrants, and/or options to an investor or institution in order to raise capital. Pot stocks have had no issue raising capital, but it's also ballooned their outstanding share count in the process. What's more, with convertible debentures, warrants, and options becoming especially common in these deals, the dilution of new shares being added often hits a few months to a few years later. It can be an unwelcome surprise for shareholders.

For instance, in late December I noted that The Supreme Cannabis Company had ballooned its outstanding share count from 9.63 million shares to 192 million (based on its Canadian listing) in roughly four years. Yet, it still had 82.8 million outstanding warrants, 17.4 million stock options, and over tens of millions of dollars in convertible debentures. This dilution can weigh down EPS, which is what might be happening.

Though sales growth looks to be impressive, full-year EPS for Canadian marijuana stocks may not live up to expectations.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong